OlsenBlog

Financial markets still follow business conventions that were adopted at a time when transactions were executed manually. Hidden to the public are the details of processing of the trillions of USD transaction volumes traded on a daily basis in the world’s financial markets. Given the huge amounts of money involved, one would assume that the technology is state of the art but in actual fact this is not the case. The settlement of financial market transactions follows business conventions that were defined, when banking was done without the help of modern computers and processes were manual. This explains, why even today international payments take two business days, which is quite extraordinary in our age of instantaneous communication. This archaic payment system has a significant impact on financial market stability.

Financial markets as a nervous system

The global economy is a complex system where financial markets are the nervous system that disseminates signals. From our every day experience with complex systems – our human body is such a system – we are aware that minor deficiencies can have a disproportionate impact. Financial market conventions may appear as petty details of execution and therefore irrelevant, but in actual fact the subtleties of execution have a big macroeconomic impact.

Electronic trading

Today, there is a stark contrast between how traders initiate and conclude trades and how these transactions are settled where financial assets are actually exchanged between buyer and seller. 80% or more of the transaction volume is concluded electronically over a computer: traders sit in front of computer screens observing price graphs with real time bid and ask prices. Literally, with a mouse click they buy and sell millions of assets, such as buying EUROS and selling USD. Within seconds and minutes they can make any number of trades.

2 day settlement of trades

Settlement of a trade is the exchange and delivery of the underlying assets. The completion of a transaction occurs two business days after its conclusion; if for example a foreign exchange deal is concluded on Friday, it is settled the following Tuesday. The time of delivery varies for different assets; for currencies it is generally 2 days, for equities typically 3 days, and only for a few assets is it a day. Delivery takes so long because the banks use old mainframe computers that process transactions in batches. During the course of the day the computer queue the transactions and then process them at night. Transactions are processed in batches, which run in 24 hour cycles and so the banking infrastructure can only make interest payments for positions that are open over night. For currency markets, the positions have to be open at 5 PM Eastern Standard Time. If positions are closed out before 5 PM EST, they do not pay interest, whether they have been open for a few seconds or 23 hours. The batch based banking infrastructure means that intra-day traders, who open and close position during the course of a day and do not have open at 5 PM EST do not receive or pay interest.

90% is intra-day trading

The daily transaction volume in today’s financial markets is gigantic, for the foreign exchange market alone the transaction volume is close to 4 trillion USD or equivalent to 30% of the US GDP. Trading happens at a high pace with traders opening and closing positions in rapid succession. It is estimated that 90 to 95 percent of the positions are held for less then 24 hours, typically for only minutes or a few hours. So it is only 5 to 10 percent of the total volume of positions opened and closed that pay interest. The standard textbooks discussing interest rates assume that interest is paid on all transactions, but this is not the case, quite to the contrary, 90+ transaction volume pays no interest.

Payment of interest is a compensation for the risk of holding the underlying asset, which needs to be paid pro rata temporis, as is the case for the billing of electricity usage or the time spent on a telephone conversation. Today, interest rate payments are discrete, no interest payments are made for positions held intra-day, i.e. not beyond 5 PM EST. Interest is only paid, if positions are held beyond 5 PM and then accrues in daily increments.

Phenomenon of carry trade

For the Japanese Yen, which pays a paltry 0.05 percent interest, the bias introduced by the batch based settlement system is marginal, whereas for the South African Rand, which today pays 7 percent interest, the bias is big: the intra-day trader pays no interest, whereas the inter-day trader keeping the position open over night that is longer than 5 PM EST receives interest. This has the effect that traders going short South African Rand intra-day, do not have to pay interest and there is thus a hidden subsidy to sell the South African Rand. Because of this subsidy there are at the margin more traders shorting the South African Rand than would otherwise be the case. The central bank of South Africa has to compensate for the downward pressure exerted by the intra-day traders shorting the currency by setting daily interest rates higher than would be the case otherwise. This gives rise to the so-called ‘carry trade’, where intra-day traders earn a higher return than warranted by the long-term risk. Long-term investors regularly take advantage of this outcome and buy currencies paying a high rate of interest with the effect that high interest rate currencies have a tendency to appreciate, which is, however, interrupted by occasional rapid sell offs, when the market has gotten ahead of itself and there is a cascade of margin calls.

For a long time Economists have observed that high interest rate currencies have a tendency to appreciate. They have been at a loss to explain this behavior, because according to standard theory, high interest rate currencies should depreciate. In our analysis the explanation is the bifurcation between intra-day trading, where no interest is paid, and inter-day trading with interest rate payments.

Yield curve starts at 1 day

Today, the shortest interest rate payment is for positions held over night, i.e., one day. Accordingly, the yield curve starts at one day and extends up to ten for most fixed income markets and occasionally up to 30 years, as in the U.S. The one-day interest rate is a benchmark in the financial system, which is used to price a whole range of other interest rate products. Changes in the one-day interest rate permeate the fixed income market and affect the real economy, where increases in the one-day rate of interest, stifle the real economy.

In extreme situations, when confidence in global currency markets wanes, central bankers have to hike the one-day interest rate as a measure of last resort to protect the currency. As the one-day interest rate is a reference for the real economy, any increase in interest rate disrupts the real economy and is a huge cost. In Turkey, in 2000 and 2001, for example, the central bank had to increase interest rates to 8′000 percent at the height of its crisis, driving many banks and corporations into bankruptcy with over 1 Mio people losing their jobs.

If the yield curve starts with the one-second interest rate, the central bank can, in an emergency, increase the second interest rate as a signal to the currency markets to bring the flow of buyers and sellers back into balance. The second interest rate is a factor of 86′400 (number of seconds per day) away from the daily interest rates, thus there is a lot of time for the second interest rate to drop back to its normal level, so central bank intervention will not impact the real economy that relies on the daily interest rate as a benchmark.

Secret central bank interventions

During the past 12 months the central banks appear to have been intervening in the currency markets to stabilize exchange rates. The apparent calm in the currency markets is thus deceiving. Global investors are increasingly nervous about the finances of governments. It is only a matter of time before there will be a run on a currency. When this happens secret interventions will not be enough to stem the tide. The central bank under assault will be forced as a measure of last resort to increase the one-day interest rate, which in turn is a harsh break on the real economy. This is the last thing that the government and central bank want in such a situation but is unavoidable under these circumstances. To make things worse, the central bank action has the perverse effect within the currency market, of providing an added incentive for the intra-day traders to short the currency: this is like flying a plane with inverted steering, where pulling up the plane actually has the reverse effect. So initially, the action of increasing the rate of interest will actually make things worse and the currency will drop even faster. So the central bank will be forced to raise interest rates even more than initially anticipated. The way out is to introduce second-by-second interest rate payments, where all traders, both intra-day and inter-day traders, have to pay interest.

Digital Age

The global economy is based on instant communication, be it over the Internet or telephone. The financial system, which transacts trillions of USD on a daily basis, is electronic in terms of trade initiation but settlement is batch based and takes two business days. This is an anachronism and has the effect that 90 percent of all the trading is subject to the wrong incentives, because there are no interest rate payments. This destabilizes the currency markets and is the reason for the existence of the carry trade. Even more dangerous, the central bankers do not possess the appropriate tools to stabilize currency markets in case of emergency.

Technology of second by second interest rate payments

The technology for second by second interest rate payments has existed for several years and has withstood the test of practice and is ready for large-scale implementation. Introducing it is not expensive. As first step, we need public awareness for the issue. Second, central bankers and governments have to twist the arms of the big investment banks that dominate the currency and fixed interest rate markets and force them to introduce instant delivery with second by second interest rate payments. The big investment banks will need some convincing to give up the hidden profit margins due to the non-transparency of the old system. These vested interests cannot stand in the way of the overall social benefits of instant delivery with second by second interest payments. The benefits include more stable financial markets, disappearance of misalignment due to carry trade, lower interest rate volatility with improved economic growth and last but not least a reduction of systemic risk due to instantaneous settlement.

January 14th, 2010 | High frequency finance, News | RSS feed